Mortgage market(fin crisis)(1) 1


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Mortgage market(fin crisis)(1) 1

  1. 1. Mortgage Markets & Financial Crisis 1
  2. 2.  Mortgage Markets Subprime Market Financial Crisis Economic Recovery 2
  3. 3.  Fixed-rate versus adjustable-rate ◦ A fixed-rate mortgage locks in the borrower’s rate  Financial institutions that hold fixed-rate mortgages are exposed to interest rate risk  Borrowers with fixed-rate mortgages do not benefit from declining rates ◦ An adjustable-rate mortgage (ARM) allows the mortgage rate to adjust to market conditions  A common ARM uses a one-year adjustment with the interest rate tied to the average T-bill rate over the previous year  Borrowers with ARMs face uncertainty about future interest rates  Using ARMs, financial institutions: Can stabilize their profit margins and face less interest rate risk than with fixed-rate mortgages 3
  4. 4.  Types of mortgages ◦ 30-year fixed ◦ 15-year fixed ◦ ARMs ◦ Equity Lines Creative Mortgages ◦ Intro (teaser) rates ◦ Stated income & asset ◦ Negative amortization loans (pick-a-pay) Mortgage Lending ◦ What are the characteristics in which a loan should be made? 4
  5. 5.  Fannie Mae: ◦ Issues debt securities and uses the proceeds to purchase mortgages in the secondary market Freddie Mac: ◦ Ensures that sufficient funds flow into the mortgage market Ginnie Mae: ◦ Is a wholly-owned corporation by the federal government ◦ Supplies funds to low- and moderate-income homeowners indirectly (provides guaranties) by facilitating the flow of funds into the secondary mortgage market As a result of these three entities, the secondary mortgage market SHOULD BE: ◦ very liquid ◦ have a lot of funding 5
  6. 6.  The most common are mortgage pass-through securities ◦ A group of mortgages held by trustee serves as collateral ◦ Interest and principal on the mortgages are sent to the financial institution, which passes them through to the owners of the mortgage-backed securities ◦ Financial institutions earn fees from servicing the mortgages while avoiding exposure to interest rate risk and credit risk Interest rate risk on mortgage-backed securities ◦ Payments received from pass-through securities are tied to the payments sent to security owners ◦ Institutions can insulate their profit margin from interest rate fluctuations 6
  7. 7.  Pooling and repackaging of loans into securities ◦ Investors in these securities become the owners of the represented loans ◦ Allows for the sale of smaller mortgage loans that cannot be easily sold individually ◦ Can reduce a financial institution’s exposure to default risk or interest rate risk 7
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  9. 9.  Interest rate risk Prepayment risk Credit risk 9
  10. 10.  What is a subprime loan? A loan made to a person with less than perfect (prime) credit Other Characteristics of subprime loan ◦ High LTV ◦ Poor cash flow to debt ◦ Improper documentation 10
  11. 11.  Bubble in housing market Housing market drop How did Financial Institutions get into trouble?  Bad Mortgages (Subprime Market)  Bets on financial subprime market (derivatives)  Example: CDS
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  14. 14.  Homebuyers / Investors ◦ Increase use of ARMs and Subprime borrowers finding more ◦ Overzealous investors ◦ Crazy buyers Builders ◦ Over building the market ◦ Too much supply and inventory of homes an now cutting prices Underwriters / Banks / Mortgage Brokers / Appraisers ◦ Lending money with no guidelines ◦ Poorly Structured Loans  Stated income, stated assets, poor documentation  ARMs  Buy downs / Intro-rates  Payment Options (Pick-a-payment with Negative Amortization)  More subprime loans and lower subprime margins 2.8% to 1.3% 15
  15. 15.  Securitization – passing the risk along (Credit Agencies) ◦ Due to securitization loans with a high risk of default could be originated, packaged and the risk readily transferred to others. ◦ The securitized share of subprime mortgages (i.e., those passed to third- party investors) increased from 54% in 2001, to 75% in 2006. Central Bank (FED) ◦ Kept interest rates too low does not try to avoid bubbles ◦ Roots of credit crisis laid at Feds door (2007)  Federal Reserve lowered the federal funds rate target from 6.5% to 1.0% because inflation was thought to be low  Trying to help the economy after Sept. 11th and bubble 16
  16. 16. Economic Recovery? 17